Categorized | Economy

Monetary Policy, Interest Rates, and Investment Bubbles…

One of the main criticisms of using expansionary monetary policy to try to stimulate economic activity during a recession goes something like this: The purpose of expansionary monetary policy is to lower interest rates in order to encourage consumption and investment. This works because, if your money isn’t going to earn much interest anyway, you might as well spend it, and, if you’re a business, it’s cheap to borrow in order to purchase new capital in order to expand or undertake new business activities. However, the fact that interest rates are artificially low suggests that some businesses that get started aren’t actually good enough to survive when interest rates are at normal levels, so we get investment bubbles.

Even Soltas argues that these concerns appear to be unfounded. Specifically, he points out that historical data shows that businesses founded during recessions are actually more likely to survive than businesses founded during good economic times, whereas, if the aforementioned investment bubbles were distorting investment in an unproductive way, we would instead see a bunch of vegan flaxseed cupcake businesses spring up during recessions and then fail when economic times (and interest rates) return to normalcy.

Source: About.com
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